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The 6-Week Options Trading Kickstarter: Options Pricing Basics

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Steve Smith breaks down the basics of options pricing.

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MINYANVILLE ORIGINAL

Editor's note: To help investors get their feet wet with options trading, Minyanville has launched this "6-Week Options Kickstarter," an educational series aimed at increasing understanding of the basic nuts and bolts of options. In this series, veteran options trader Steve Smith will take you through options fundamentals with an emphasis on real-world applications. Note: Intermediate or advanced-level traders may get more mileage out of Minyanville's 9 Weeks to Better Options Trading series.

One of the keys to successful options trading is judging whether an option is fairly priced. Unlike stocks, options have a theoretically unlimited supply, and thus an options market will never independently experience a short squeeze. And because the options are tied to stock prices, the value of the puts must be related to the calls or there would be risk-free arbitrage available. It is the market maker's job to keep the puts and calls in line. But this doesn't mean that prices can't vary widely within an individual issue over different time frames.

The most commonly used apparatus for valuing options is the Black-Scholes model, which considers five factors in calculating a particular option's theoretical fair value:

1. The price of the underlying security

2. The strike price of the option

3. The time, or expiration date of the option

4. Interest rates

5. Implied volatility (or IV)

The first four inputs are known variables. To get number five, we plug those four inputs into the Black-Scholes model. This would give us "theoretical" implied volatility, which helps us decide whether an option is cheap or expensive.

But given that options trade regularly, there is already an "actual" implied volatility assigned to each option based on its price, which is constantly updating in real-time. Therefore, our mission, should we choose to accept it, is to determine whether an option's current price looks cheap or expensive based on its volatility level.

Let's go over exactly what implied volatility is. Implied volatility is a measure of the probability of a certain percentage price move occurring within a given time frame. It is typically anchored to the underlying stock's historical or realized volatility, which measures recent price action.

A notable exception would be biotechs since shares of these names can trade rather benignly for months on end, while the prospect of volatility-inducing events, like FDA rulings, keeps implied volatility at elevated levels. For example, the 30-day historical volatility (or HV) of Dendreon (DNDN) is 79% while the current implied volatility stands at 115%, suggesting that traders are pricing in the possibility of a substantial move.

By comparison, JPMorgan (JPM) has a 30-day HV of 41% while the current implied volatility is just 29%. This "discount" of IV below HV would indicate that expectations for a big stock move are settling down following the hooplah over the big trading loss.

Now let's look at how understanding historical volatility can be used to counter the "options don't work" argument put forth by naysayers who get frustrated when they make an options bet and are correct on the direction of the underlying, but don't make money.

We'll use Fusion-io (FIO) as an example.

Fusion IO, ahead of its April 24 earnings report, saw implied volatility climb up to 90%, which was well above the 52% rate at which the 30-day HV was running at this time. This was because the options market was pricing in the 10% price move that the shares had averaged over the past four earnings reports. The stock responded to the earnings with a 7% decline to $26.20. Immediately following the report, IV declined to 55%, or right back to the HV.

This type of drop in implied volatility is quite common following an earnings report or any scheduled event that has market moving implications. In this case, the combination of the options having overpriced the expected move and the post-earnings premium crush means that the value of puts did not go up much despite the drop in stock price. For example, the May $25 puts only gained $0.20 to $1.80 on the day after the earnings report.

An increase in implied volatility ahead of an event is simply the expression of a higher probability of a larger-than-usual price move within a given time frame. In this sense, an increase in implied volatility is an artificial expansion of time. In other words, what could happen over a long period of time is now being priced into a shorter period of time, and that makes sense ahead of a volatility-inducing earnings report.

Understanding where IV stands relative to HV, and why it is at the current level is crucial to assessing current option prices, and anticipating future moves.

If a volatility-inducing event like an earnings report is anticipated, implied volatility will revert back to the mean after the event. But if there is unanticipated news like a surprise FDA ruling on a drug, IV will spike.

With Fusion set to report earnings on August 9, expect implied volatility to start to creep up in coming weeks -- and then expect it to drop back towards 50%, or close to historical volatility, immediately following the report.

One site that offers an option calculator and historical and implied volatility readings over various time periods is iVolatility.com.

Time Is Square, Man

There's a basic math formula used in the Black-Scholes model that is a good starting point for understanding the rate of decline in an option's value due to the passage of time (also known as time decay or theta). Basically, we use the square root of time to calculate and plot time decay. The math involved in the nitty-gritty of evaluating theta can be extremely complex, so focus on this: Time decay accelerates as expiration approaches, meaning that theta is defined on a slope.

For example, if a 30-day option is valued at $1.00, then the 60-day option would be calculated as $1 times the square root of 2 (2 because there is twice as much time remaining). So all else being equal, the value of the 60-day option is $1.41, or $1 times 1.41 (1.41 is the square root of 2). A 90-day option would be $1 times the square root of 3 (3 because there is three times as much time remaining) for an option value of $1.73. (1.71 is the square root of 3).

If you'll notice, the premium of the 60 day over the 90 day ($0.32) is less than that of the 60 day over the 30 day ($0.41). So again, the important takeaway is to realize that the closer an option gets to expiration, the rate at which time value decays gets faster.

Here are some other basic concepts you need to know about theta:
  • An options theta can be calculated as follows: If a particular option's theta is -10, and 0.01 of a year passes, the predicted decay in the option's price is about $0.10 (-10 times 0.01 is 0.10).
  • At-the-money options have the highest theta. Theta decreases as the strike moves further into the money or further out of the money. In-the-money options are mostly composed of intrinsic value (the difference between the strike price of the option and the market price of the underlying), while out-of-the-money options have a larger implied volatility component.
  • Theta is higher when implied volatility is lower. This is because a high implied volatility suggests that the underlying stock is likely to have a significant change in price within a given time period. A high IV artificially expands the time remaining in the life of the option, helping it retain value.
Just as it isn't necessary to know how to build an engine to drive a car, you don't need to know all the math behind the pricing of an option. But it certainly helps to understand the concepts that make them stop and go. And with experience, they'll safely take you where you want to go.

Here is a complete schedule for the 6-Week Options Trading Kickstarter:

1. What Are Options, and Why Should We Care About Them?
2. Option Pricing: The Five Components
3. Meet the Greeks
4. How to use Options: Three Basic Principles
5. Covered Calls
6. Hedging, Portfolio Protection, and Avoiding Disaster

Twitter: @steve13smith

For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.
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No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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